Banking Law

Yesterday's The Wall Street Journal disclosed a frightening factoid that those of us who represent community and regional banks have been aware of for some time now (unfortunately, for some of our clients).

U.S. banks have been charging off soured commercial mortgages at the fastest pace in nearly 20 years, according to an analysis by The Wall Street Journal. At that rate, losses on loans used to finance offices, shopping malls, hotels, apartments and other commercial property could reach about $30 billion by the end of 2009.

[...]

The $30 billion estimate is based on financial reports filed by more than 8,000 banks for the first quarter. The trend continued as a handful of major banks reported second-quarter results, including Goldman Sachs Group Inc., J.P. Morgan Chase & Co. and Bank of America Corp. Regional banks tend to have higher exposure to commercial real estate than these big financial institutions.

[...]

In contrast to home loans, the majority of which were made by about 10 lenders, thousands of U.S. banks, especially regional and community banks, loaded up on commercial-property debt.

There are a couple of factors at play. First, community banks find it extremely difficult to play with the big boys in the retail banking game. Consumers routinely expect a lot in the way of service, much of which requires an investment in technology that small banks can't afford, certainly not through infrastructure investments and often not through third party service providers. In addition, the costs, hard and soft, of regulatory compliance with respect to consumer lending are substantial. Many community banks have turned to commercial lending, especially commercial real estate lending, as one of the few avenues left open to them where they can not only make decent money but provide better (i.e., more personal) service to the borrower than many of the big banks. Thus, their portfolios are often laden with CRE. Obviously, this is a bad time to be so burdened.

Ironically, small banks appear to be much less aggressive in recognizing losses than their bigger brethren. According to the Journal analysis, the largest banks, with assets of more than $100 billion, saw charge-offs roughly quadruple last year, while losses at many medium-size banks grew at a much smaller rate of 120%.

I'm not convinced that the difference in write down "aggressiveness" between small and large banks is "ironic." Aggressive write-downs usually mean aggressive hits to capital, and in many cases community banks are disproportionately affected by write-offs that a large bank could take in stride. Moreover, as we've seen thus far from the federal bank regulators, especially the FDIC, massive CRE write-offs are a prelude to a death spiral for banks that are "too small to save." The federal regulators have been in the process of beating up the commercial real estate portfolios of community banks nationwide in the same manner they hammered the commercial real estate loan portfolios of banks and thrifts in the Southwest during the 1980s. It's deja vu, all over again.

Experts cited in the article worry that bank regulators and banks aren't being sufficiently proactive. They worry that if the losses remain "buried" in loan portfolios, the pain of working through troubled commercial real estate will be unwisely prolonged. For community banks, however, the concern is that in being zealous to require write downs and loss reserves, the regulatory "doctors" may kill the "patients." Both concerns are valid.

Commercial real estate pain is in its early stages and it's only going to get worse. Let's hope the ill survive the treatment.